Why Should a Firm Have a Capital Structure Policy, Case Study Example

Financing policy is important to Du Pont because it supports its corporate strategy.  To fund its strategy Du Pont needs assured access to external capital markets. Capital structure policy determines the degree of access and the terms on which the firm will be able to raise funds. The objective in determining a target debt ratio is to achieve as many benefits of debts as possible (tax savings) without exposing the firm to undue risk of financial distress. But it would risk high debt costs and possible loss of capital market access in periods of adversity.  This could severely constrain its ability to achieve strategic objectives that require constant funding during periods of adversity.

Compare and contrast the two debt policy alternatives outlined in case Exhibit 8 (Slide #18) for 1987. see attached 

-What bond rating would Du Pont receive under each alternative?

When the debt is 25 % the projected bond rating is AAA or AA

When the debt is 40% the projected bond rating is A or BBB

-How would its financial performance, financial needs, access to capital, and financial risk differ under the two alternative debt policies?

When the debt is 25%, the financial needs are larger equity needs and high-rated debt needs access to capital flexibility, when there are concerns about availability and terms of equity financial risk would be low.

When the debt is 40%, financial needs are smaller equity needs and low-rated debt needs access to capital and concerns about cost and availability of low-rated debt financial risk are higher.

Comparison between both alternatives in terms of financial performance:

The higher debt ratio leads to higher EPS (up 18%), DPS (up 34%), ROE (up 12%), and marginally higher sustainable growth.   However, the higher EPS for the 40% debt ratio does not necessarily imply that Du Pont’s stock price will benefit from higher Leverage.  If Du Pont’s P/E ratio remains at 10, the $1 increases in EPS translates into a $10 increase in stock price.  But P/E ratios are determined by growth and risk.  While Du Pont’s sustainable growth differs little for the two debt ratio alternative, risk is much higher with the high debt ratio.  EPS is more volatile.

More generally, how should a firm determines its appropriate capital structure?

An optimal capital structure that maximizes stock price rises with the debt ratio. As debt is added to the capital structure, the P/E does not fall appreciably at low debt ratios. This is usually because risk is not substantially increased. Higher EPS combined leads to stock price increases with higher debt ratios, but this is usually with marginal declines in P/E . The higher debt ratios the more the risk increases, and the P/E ratio declines more rapidly than EPS. This makes stock price falls and debt is added to capital structure. Finally, the stock price rises, reaching an optimal point, and then declines.

(a). What impact does leverage have on the prospects and performance of a company?

Financial leverage refers to the use of debt to acquire additional assets. It may decrease or increase return on equity in different conditions, like financial over-leveraging means incurring a huge debt by borrowing funds at a lower rate of interest and using the excess funds in high risk investments in order to maximize returns. The most urgent risk of leverage is that it multiplies losses. A corporation that borrows too much money could become bankrupt during a downturn.  Less-levered company might survive. An investor who buys a stock on 50% margin will lose 40% of his money if the stock declines 20%(b). What problem arises from employing too much debt? too little debt?

Problems from too much debt.

Too much debt results in cash flow problems. This means the company will have trouble paying the loan back. High debt companies are also seen as a high risk by potential investors making it even harder for them to gain liquidity. Debt financing can leave the business vulnerable when sales take a dip. Debt can make it difficult for a business to grow due to the high cost of loan repayment.

Assets of the business can be held as collateral to the lender. And the owner of the company is often required to personally guarantee repayment of the loan.

Problems from too little debt:

Ironically, too little debt results in a lower stock price, because debt means a company is venturing into new projects. Understandably, too much debt also lowers the stock price. The ideal situation is to have a balance between the two.

(c). What indications does a firm have that its leverage is too high? too low?

Employing too much debt, the signs are bond-rating downgrades, increase in debt costs, declining P/E ratios. For employing too little debt, the signs are dilution from selling equity.